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How major regulations impact business decisions of companies and their market performance

 Introduction

Government regulations often have a tell-tale effect on the stock market of any country. While some might impact one or two sectors in particular, some major ones (for example de-monetization, interest rate policies, etc.) can have widespread effect on the nation’s economy. There is often a fine line between over and under regulation. The government, emphatically declaring itself the lifestyle monitor for its citizens has this time come up with decisions to regulate what it considers ‘good’ or ‘bad’ for the majority, especially young and impressionable adolescents. The policy rule has resulted in the traditional tobacco and carbonated drinks companies benefitting to an extent, however has put a bit of a question mark over the business decision and strategies for the new and upcoming segments. The stock market also reacted in a predictable fashion, with many corporates issuing statements in relation to the regulation announcement.

 The ‘regulations’

Taking cue from around the world, the Indian government has banned e-cigarettes and increased taxes on caffeinated drinks, which are now in tax parity with carbonated drinks.To many, the move seemed a bit superficial, considering that the Government took this step of setting up a ban on e-cigarettes, but not traditional cigarettes, which are said to be more harmful when consumed.

The justification came soon enough! E-cigarettes were introduced in the market to help regular smokers to quit smoking. However, the younger generation and school children, who have not tasted traditional bidi /cigarette and are much more aware of the stated side effects of those products, started taking up e-cigarette as a “style statement”. Whichever way we look at it, there have not been a lot of research done, or published on the stated harmful effects of e-cigarettes, and the youngsters are simply choosing the lesser of the two evils!India is home to a more than 100 million adult smokers, making it a huge potential market for e-cigarette companies to grow at an exponential rate. In addition, they have been introduced in ~1500 flavors. One would pause to think that they have been marketed as a “Gateway Drug” – whose appealing flavors are putting children at a risk to become addicted to nicotine.And hence, to curb this augmented trend amongst the young generation, the Government banned the production, manufacturing, import, export, sale, distribution and advertising of e-cigarette in India. This also coincides with various studies being published around the world on the harmful and addiction causing effects of these products.

To add more fuel to the fire, a second policy rule was passed to bring the GST on caffeinated and energy drinks at par with carbonated drinks (at a whopping 40%!). Initially, when carbonated and aerated drinks were added to the category of 40% GST in India, the Government took some fizz out of these companies, which were growing at a compound annual growth rate of ~11% before the tax regulations.The increased tax rate had forced most of them to pass on cost increase to the consumers, which in turn led to a drop in their sales. In addition, the companies started deploying various innovative tactics to get back into the game – Thums Up launched “Charged” which used caffeine in large amount and hence was categorized under tax slab of 18%. Some also started adding minimal quantities of fruit juices to their original recipes in order to be classified under a lower GST bracket. This did not, hence, solve the whole issue of taxing ‘sugary’ drinks higher to lower consumption.

 Another socio-economic factor emerged from studies that overweight and obesity rates in children and adolescents were increasing not just among the higher income groups in the cities, but also amongst the lower income groups. The beverage companies seemed to be tackling the issue of increased awareness amongst the urbanites and started selling low, penetrating into the rural areas.The Indian government has followed in the footsteps of its major counterparts across the globe in this regard. In 2014, Mexico became the first country to impose a tax on sugary drinks and studies have shown consumption reduction by ~7.5%. Various other countries such as France, Philippines, Sri Lanka, Singapore, U.S have also taxed sugar sweetened beverages higher, to discourage consumption.

 The ‘impact’

Let’s first look at the market reactions to the news of banning e-cigarettes in India.

On one hand, this policy has simply busted the emerging e-cigarette market in India, which was expected to reach $45.3 million by 2024 (Source: PS Market Research, August 2019). Even the traditional cigarette makers had made some forays into this segment, based on low barriers of entry and high projected growth rate.This is one of the typical examples where a completely justified cash flow projection of a company, or a business segment, can receive a swift death blow to due to a new government regulation. This policy was declared even though there has been no independent study conducted in India on e-cigarettes, which were still enjoying their novelty phase.Ironically, hours after the ban was announced, market value of the country’s biggest three traditional tobacco and cigarette companies surged ~5.0% on an average. This regulation will further increase their market share, which they previously stood to lose to their new and seemingly fancy cousin.

 On the second regulation, most corporates have come out with statements that the GST increase on caffeinated and energy drinks will not have a material impact on the sales projections. In a country like India, most of the beverage companies have the potential to increase volumes and hence, not pass on the increased cost directly to the consumer. Alternately, reduction in corporate tax rates is increasingly being viewed as an offset to this rule.The market seems to agree to this analysis as well. Most Indian beverage companies, including bottlers did not face any significant sell-off. Investors are understanding that there will not be particularly negative impact on manufacturers as they have been paying similar taxes earlier on most of their business segments. Having said that, firms looking to re-align their product segments would probably have to rethink their strategy. And this is what the investors need to focus on going forward. Any such previous projections will have to be discounted and valued differently now.

 Bottom line

 Banning certain products (or categories) and increasing taxation are the government policies that directly affect businesses and compel them to rethink and realign.In such a scenario, staying on top of regulations is essential for all investors, failing which there can be a potential loss in the portfolio. It is important to periodically refresh one’s knowledge and stay current about what is changing in business.

 Many government policies affect the projections and estimates of corporates, especially taxation rules, and the market reacts very swiftly to any such negative news in particular. As an investor, one needs to rationalize and check clearly for tangible impacts on business performance of corporates, and not react with a herd mentality. In addition, if one invests in niche areas (e.g. e-cigarettes), it is important to realize that one regulation can make or break such an industry. Therefore, it is not prudent to invest all of one’s money on one idea or category, and opt for diversification.